The Becker-Posner Blog

correction

I apologize for two typos in my last post on extending unemployment insurance.

Toward the end it should read "4.5 million persons were hired in May 2010"

At the end of my post I inadvertently included some statistics on the voting on this bill, and provide a reference for these data.

Gary S. Becker

Should Unemployment Compensation be Extended? Becker

 

President Obama during this past week signed into law extending unemployment benefits to a maximum of 99 weeks, or almost two years, for persons who have been unemployed for over half a year and have exhausted their state benefits. The degree of extension varies among states depending on a state’s unemployment rate, with higher unemployment states getting longer durations of coverage. The bill that became law is highly partisan, passing with almost all Democrats, 31 House Republicans, and only 2 Republican senators.  I believe the law extends unemployment benefits for too long, although the economics of optimal unemployment insurance gives a less than certain answer.

Unemployment insurance tries to balance two conflicting goals. One is to protect at least some of the earnings of workers laid off from their jobs through no fault of their own, while the conflicting goal is not to make unemployment status so comfortable that workers try to get laid off, and do not look seriously for jobs when they are unemployed. The first aim is a typical goal of insurance against bad outcomes, while the second goal is to reduce the degree of “moral hazard”; that is, to reduce the incentive of persons to reduce their efforts to remain employed and look seriously for work when unemployed because they have insurance against the cost of being unemployed.

One typical way insurance tries to reach a compromise between these conflicting goals is to have a deductible that is paid by insured persons, such as the $500 deductible many car owners have on their automobile insurance. The trouble with practically all the state-run unemployment insurance plans is that they typically have no or a minimal deductible because they provide coverage essentially from the first week of unemployment. In addition, they usually limit coverage to a fixed number of weeks, such as 26 weeks. This is an inefficient and costly approach since practically all the unemployed can readily cover their first several weeks of unemployment from savings, spouses’ earnings, or borrowing on credit cards and in other ways. Unemployed workers usually run into financial trouble only when they have been unemployed for an extended time. An optimal unemployment insurance plan would make unemployed workers responsible for their first month or two of unemployment, and mainly spend unemployment insurance resources on the longer-term unemployed.

A second insurance approach to the moral hazard problem is to require significant co-payments, so that the insured have to pay a portion of any additional losses they experience after they exhaust the deductible. American unemployment insurance plans usually do pretty well on this by only paying about half or so of the earnings the unemployed had received when they were employed. Many European plans had usually replaced most or all of the earnings of the unemployed, and covered unemployed for many years. After they learned the hard way the prediction of economic theory that this encouraged significant increases in unemployment, several countries greatly cut back both the duration and payment (i.e., replacement) rates for the unemployed. Interestingly, In Germany this was done under a center-left Social Democratic government.

This analysis of insurance provides background for evaluating the new extension of unemployment benefits for the longer-term unemployed. The approximately $30 billion committed to this extension has been partly justified as a stimulus to what may be a slowing US economy. However, since any “stimulus” from $30 billion would be paltry even to the most optimistic stimulus calculations, such a stimulus can hardly be a serious justification for this extension of benefits. This is especially the case when federal budget deficits have been so large during the past couple of years, and there is no serious evidence that the $800 billion stimulus package passed over a year ago has had much stimulating effect on unemployment or GDP. Much of the evidence usually cited about number of jobs created by the stimulus package is based on terrible analysis. Any new hires under stimulus money is assumed to be net jobs created by the stimulus rather than a transfer of employment from non-stimulus activities to stimulus-supported activities.

So the case for the new law rests on its insurance provisions rather than on its stimulus capabilities. I argued earlier that covering the longer-term unemployed is the more optimal way to approach unemployment insurance since the long-term unemployed face the largest economic hardship. From that viewpoint, extending the duration of coverage beyond 6 months makes sense in an environment where the unemployment rate remains excessively high at 9.5%, especially if the extension is accompanied by the elimination of unemployment coverage for the first 6-8 weeks of unemployment.

However, the actual large extension poses a major risk of creating an unemployment culture where men and women remain “ unemployed” for years. Once the period of unemployment becomes long enough, people begin to get the habits from being unemployed for a long time: they sleep late, develop various leisure interests, and at the same time their work skills depreciate from not using them for an extended period. Studies have shown that skill depreciation is a serious effect of being unemployed for a long time.

Some might retort that this argument is persuasive during periods of normal unemployment rates, perhaps 7% and under, but not when jobs are scarce, the unemployment rate is over 9%, and it is coming down slowly. There is merit to this response, but on the other hand, the JOLTS data show that even with the current high unemployment rates, about 4.5 4 million persons were hired in May 2010 (and about the same number are either being laid off or quitting their jobs). So for the most part, even the long term unemployed can find jobs if they are willing to take a cut in their earnings, and/or move to other industries and occupations.

This analysis leads me to the following conclusions. During bad times, 6 months of unemployment compensation may not be long enough, but the 2 years in the new law is too long.  About 9 months of unemployment compensation would be the right length. Anyone unemployed longer than that would lose these benefits. If they want to work they should be forced to adjust, at least temporarily, to the bad economic environment, and accept jobs that they would turn down during good economic times.

 

 

 

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 [K1]“The vote in the House was 272 to 152, with 31 Republicans joining 241 Democrats in supporting the measure. Voting against were 142 Republicans and 10 Democrats.”

 

NYT: http://www.nytimes.com/2010/07/23/us/politics/23jobs.html?scp=3&sq=unemployment%20benefits%20extension&st=cse

 

Fewer senators crossed partisan lines (2 Republicans and 1 Democrat) on this issue.

Against Extending Unemployment Benefits—Posner

I do not favor extending unemployment benefits. The bill signed into law by the President last Wednesday would extend unemployment benefits by up to 13 weeks (depending on a state’s unemployment rate) for persons, estimated to number some 2.3 million, who have been unemployed for six months or longer, up to a maximum of 99 weeks (almost two years), at a total cost to the government estimated at $34 billion.

 

I would not object to the government’s giving the states some fraction of $34 billion to enable them to make additional welfare payments to persons experiencing serious economic hardship. But extending unemployment benefits beyond the standard six-month limit is a bad idea.

 

As Becker points out, the total amount of the additional benefits is too small to have a significant positive effect on employment—and for the further reason that a transfer payment cannot be assumed to have a positive effect on consumption or investment. The effect will depend on what the recipient of the transfer does with it. If he saves it, at least in an inert form such as cash or a federally insured demand deposit that the bank in which the money is deposited uses to buy a Treasury security, then it will not stimulate production and hence employment. Even if he uses it to buy something, it may turn out that the seller is selling from inventory and doesn’t plan to restock, in which event the effect on production will depend on what the seller does with the money he receives for the sale—maybe he will save it in some inert form!

 

Far from being effective as stimulus, the extension of unemployment benefits will have two negative effects on employment. First, it will increase the opportunity cost of the recipient’s rejoining the labor force. Unemployment benefits are set lower than earnings to reduce the moral hazard that Becker discusses, but the gap between benefits and earnings is narrowed by the costs of work (such as commuting, and any disutility associated with work, such as fatigue and boredom) and by the benefits of household production and of leisure—and those benefits, unlike earnings, are not taxed. The gap is so small for many unemployed people that studies show that they do not begin a serious job hunt until their unemployment benefits are about to expire.

 

So extending or otherwise enhancing unemployment benefits, far from stimulating employment, is likely to reduce employment and so slow the pace of economic recovery.

 

Second, extending unemployment benefits has a negative long-term effect on employment. The longer a person is unemployed, the less likely he is ever to return to the labor force, at least in a job comparable to the one he held before becoming unemployed. Apart from erosion of skills and of the habit of working, persons unemployed for a long time are unattractive hires because employers are suspicious of these persons’ attachment to or aptitude for work.

 

Thus the net effect of the just-enacted extension of unemployment benefits is likely to be to reduce employment and output. And while the amount of the benefits involved in the extension is not large, the negative effect on the economy may be if a substantial number of the 2.3 million persons who will be receiving the benefits are unemployed for a longer time, as a result, than they would otherwise be.

 

So the extension has to be defended if at all as a welfare measure. It is a bad measure because it is not means-tested. To be counted as unemployed you have to be looking for a job, so one can assume that the unemployed are involuntarily unemployed and so would prefer to work. But that doesn’t mean that they necessarily face economic hardship as a result of being unemployed. They may be unemployed because their attachment to the labor force is actually quite week; they do not try very hard to meet their employer’s expectations and so are quick to be laid off in bad times, or their search for employment is lackluster. They may have large savings or a high-income spouse. No doubt the bulk of the long-term unemployed are hardship cases, but it is only hardship cases that make a strong claim on a welfare program.

 

The fact that not all persons who have been unemployed for a substantial period of time are hardship cases reinforces my concern that extending unemployment benefits will cause disemployment. The persons who can afford, as it were, to be unemployed are likely to pocket any additional unemployment benefits that they receive and slow their search for a job.

Abuse of Presidential Power? Posner

The Bush Administration, especially in the person of Vice President Cheney, had an expansive view of presidential authority. It was articulated as an interpretation of the Constitution, in particular Article II, which is about the presidency. Truman similarly took an expansive view of presidential authority when he seized the steel industry during the Korean War, but the seizure was overturned by the Supreme Court. (The Bush Administration had a mixed record in the Supreme Court in defending its expansive view of presidential authority, which centered on antiterrorist policy.) Clinton used administrative regulation to try to get around the Republican Congress with which he had to deal after the 1994 election. Other Presidents, notably Lincoln, were prepared in emergency circumstances to violate the Constitution, as when Lincoln suspended habeas corpus at the outset of the Civil War; it is reasonably clear that the Constitution authorizes only Congress to suspend habeas corpus.

 

There is a third type of questionable exercise of presidential power, which consists of publicly demanding that a private firm or industry or other entity conform to the President’s desire, without pretending that the President has the legal authority to require such conformity. (This overlaps with but is distinct from the concept of the presidential “bully pulpit”—the President’s power to appeal directly to the people for support of his policies.) In April 1962, for example, President Kennedy publicly denounced U.S. Steel and the other major steel companies for announcing a stiff price increase to offset the cost of a collective bargaining agreement that it had signed with the United Steelworkers union. He backed up his denunciation by threatening an antitrust investigation and made the threat credible, or at least frightening, by having his brother (the Attorney General) dispatch FBI agents to “interview” the top steel executives. The Administration had encouraged the collective bargaining agreement and was incensed at U.S. Steel’s attempt to offload the cost of it on consumers. A price increase is a normal response to higher labor costs, but the President considered it a slap in the face—his face. His public denunciation of the steel industry worked; the industry backed down and the antitrust investigation was called off.

 

President Obama has used this device of extra-legal presidential intimidation more frequently, probably, than any President. In the spring of last year he told General Motors to fire its chief executive officer, Rick Waggoner. He had no authority to do that, and didn’t pretend that he did. Waggoner went. Last month the President ordered British Petroleum to put billions of dollars into an escrow account for payment of claims for losses caused by the BP oil leak in the Gulf of Mexico. He did not pretend to have any legal authority to order this, but BP quickly complied—as it did with the President’s insistence that it cut its dividend in order to be sure of having enough money to pay all the claims that might be made against it and the fines that might be imposed on it. And the President’s criticisms of Wall Street bonuses may have been decisive in the decision of Goldman Sachs to scale down the bonuses it was intending to award for the firm’s highly profitable 2009.

 

Should a President use the prestige (one might even call it the “moral authority”) of the office, and his ability to command public attention, to obtain compliance with demands made by him on the business community that are not backed by law? I think not, apart from any distaste one may have for bullying. It makes business subject to two regulatory regimes. One is a legal regime, created by Congress and by the regulatory agencies to which Congress delegates a portion of its own constitutional regulatory power. The other is a kind of “people’s democracy” regime, in which government stirs up public anger to force businesses to comply with extra-legal government demands. This second regulatory regime operates without rules, and so subjects business to potentially debilitating uncertainty in the sense of a risk that cannot be quantified. We know from Keynes and other students of uncertainty that a common and often the sensible response to uncertainty is to freeze, in the hope that the uncertainty will dissipate over time, or to take active steps to reduce the uncertainty. Both are options for business faced with the threat of presidential wrath. A business can hire less, invest less, and build up its cash balances as a hedge against adversity. It can also redouble its lobbying and other influence activities in an effort to neutralize or deflect threats of extra-legal regulation. Neither is a healthy response; the first is downright pernicious, especially in a depression or recession, or the early stages of economic recovery. Both are responses that the threat of presidential bullying encourages.

 

Many of the President’s legislative initiatives, in particular the health reform law, the just-enacted financial regulatory reform law, and the credit card law of last year, have increased the uncertainty of the economic environment for business. These laws really haven’t settled anything; it will take years of regulatory implementation before their full impact can be determined. But in addition business has to deal with the unpredictable exercise by the President of an uncanalized extra-legal authority to bend business to his wishes.

 

It is no wonder that the economic recovery appears to be progressing so slowly.

The Abuse of Presidential Power-Becker

"Power tends to corrupt, and absolute power corrupts absolutely”. This famous dictum of Lord Acton is as relevant today as it was when stated in 1887. It applies to the private sector, such as private monopolies, as well as the public sector, but this insight has become much more important in the public sector since he wrote because of the large expansion of governmental powers during the past 70 years.

I would only add to Acton’s dictum that discretionary power is even more corrupting than the power embodied in regulations. The most dangerous trend in presidential power has been the growth in presidential willingness to take many discretionary actions that not only have little basis in law, but also frequently cause great harm to the economy and the society at large. The harm consists of both the direct damages from the actions, and the often large but indirect cost from the increased uncertainty and fear about the political environment faced by business, unions, and other groups.

Consider two examples mentioned by Posner. In 1962 President Kennedy used various threats to pressure steel companies to rescind a price increase in response to a very generous wage settlement that the industry made with the United Steelworkers union. Even many economists then believed that steel prices and steel output had a huge effect on the economy because it was claimed that steel was an important raw material in automobile production and many other goods. Yet the value added by the steel industry-the most important measure of its importance-was less than a few percent of US GDP.

Moreover, forcing the steel industry to suppress the price increase slowed down the substitution of aluminum and plastics for steel in the production of cars and other products. Prices provide important signals to an economy of the relative costs of producing different goods, which lead businesses and consumers to respond by substituting away from inputs and goods rising in price relative to other inputs and goods. The replacement of steel by other materials would have been faster if President Kennedy had stayed out of the negotiations, so that the disciplining of the United Steelworkers union and the companies could have occurred earlier.

As it was, it took only another decade for the steel industry to be turning to Washington for help through higher tariffs on steel imports, and direct subsidies. If the steel workers union and steel companies had been allowed to bargain without government interference and help, the adjustment by the industry to growing competition from other materials and steel from other countries would have been faster and more efficient. Probably too, the survival of the industry without a government lifeline would have become easier.

A more recent example is the BP oil spill in the Gulf of Mexico that is still not fully contained.  Whatever the degree of carelessness by BP, they will be fined billions of dollars as various cases brought by injured parties make their way through the courts. Such tort-based liability is justified, but there was no good economic reason for President Obama to interfere by requiring BP to create a $20 billion escrow account, and to defer its dividend payments. These were simply politically motivated acts to offset the public impression (not obviously correct) that he was too slow to act once the spill was discovered. The British have been claiming that his acts reflect a protectionist attitude of the US that is anti-foreign business.  In any case BP is strong enough to repay sizable damages without any presidential interference since its shares still have a market value of over $100 billion, even after a large decline in their value following the spill and the president’s threats.

It is still too early to evaluate the long-term harm from the president’s use of excessive authority against BP. However, the general anti-business tone of the current Congress and presidency that is reflected not only in various discretionary acts by the president, but also in proposed and actual legislation, such as the health care law, controls over executive pay, and the Dodd-Frank bill, are already slowing down the recovery from the financial crisis and recession. I have argued elsewhere (see, for example, the article by Steven Davis, Kevin Murphy, and myself in the January 4^th issue of the Wall Street Journal) that the anti-business legislation, and the uncertainty about subsequent legislation, has contributed to the slowness of this recovery compared to recoveries from prior severe recessions. Unemployment has remained sluggishly high in part because both small and large companies have been reluctant to take on additional employees in an uncertain and threatening environment. Perhaps that is good politics, but the use of presidential and congressional powers against business is surely not good economics.

Five Major Defects of the Financial Reform Bill-Becker

A 2300 page bill is usually an indication of many political compromises. The Dodd-Frank financial reform bill is no exception, for it is a complex, disorderly, politically motivated, and not well thought out reaction to the financial crisis that erupted beginning with the panic of the fall of 2008. Not everything about the bill is bad-e.g., the requirement that various derivatives trade through exchanges may be a good suggestion- but the disturbing parts of the bill are far more important. I will concentrate on five major defects, including omissions.

1. The bill adds regulations and rules about many activities that had little or nothing to do with the crisis. For example, it creates a consumer financial protection bureau to be housed at the Fed that is supposed to protect consumers from fraud and other abusive financial practices. Yet it is not apparent that many consumers were victimized during the financial boom years, or that consumer behavior had anything of importance to do with the crisis. For example, consumers who took out subprime mortgages that required almost no down payments and had low interest rates were not victimized since these conditions enabled them to cheaply own houses, at least for a while. The “victims” were the banks, and especially Fannie Mae and Freddie Mac, that were foolishly willing to hold such risky mortgages.

 

The bill gives the Fed authority to limit interchange or “swipe” fees that merchants pay for each debit-card transaction, although these fees had not the slightest connection to the financial crisis. Such price controls are in general undesirable, and hardly seem to require the attention of the Federal Reserve. The bill also gives the SEC authority to empower stockholders to run their own candidates for corporate boards of directors. Corporate boards often receive some blame for the crisis-mainly unjustified in my opinion- but stockholder election of some members will not improve corporate governance, and will probably make that worse.

 

2. The Dodd-Frank bill gives several government agencies considerable additional discretion to try to forestall another crisis, even though they already had the authority to take many actions. The Fed could have tightened the monetary base and interest rates as the crisis was developing, but chose not to do so. The SEC and various Federal Reserve banks-especially the New York Fed- had the authority to stop questionable lending practices and increase liquidity requirements. These and other government bodies did not use their authority to try to head off the crisis partly because they got caught up in the same bubble hysteria as did banks and consumers. In addition, regulators are often “captured” by the firms they are regulating, not necessarily because the regulators are corrupt, but because they are mainly exposed to arguments made by the banks and other groups they are regulating.

 

Despite the fact that regulators failed to use the powers they already had, the bill mainly adds not clear rules of behavior for banks, but additional governmental discretionary power. For example, the bill creates the Financial Stability Oversight Council, a nine-member panel drawn from the Fed, SEC, and other government agencies, that is supposed to monitor Wall Street’s largest companies and other market participants to spot and respond to any emerging growth in systemic risk in the economy. With a two-thirds vote this Council could impose higher capital requirements on lenders and place hedge funds and dealers under the Fed’s authority. Given the regulators reluctance to use the power they already had to forestall the crisis, it seems highly unlikely that this Council will act decisively prior to the emergence of a crisis, especially when a two thirds majority is required.

 

3. Insufficient capital relative to bank assets was an important cause of the financial crisis. The bill does reduce the ability of banks to count as bank capital certain risky assets, such as trust preferred securities, and gives the Fed authority to impose additional capital and liquidity requirements on banks and non-bank financial companies, including insurers. I would have preferred a simple rule that raised capital requirements of banks relative to their assets, especially capital of larger and more interconnected banks. As suggested by Raghu Rajan and the Squam Lake group of economists, the bill probably should have required larger banks to issue “contingent” capital, such as debt that automatically converts to equity when the banks are experiencing large losses, or when a bank’s capital to asset ratio falls below a certain level.

 

4. One of the most serious omissions is that the bill essentially says nothing about Freddie Mac or Fannie Mae. In 2008 these organizations were placed into conservatorship of the Federal Housing Finance Agency. During the run up to the crisis, Barney Frank and others in Congress encouraged Freddie and Fannie to absorb most of the subprime mortgages. In 2008 they held over half of all mortgages, and almost all the subprimes. They have absorbed even a larger fraction of the relatively few mortgages written after 2008. Freddie and Fannie deserve a considerable share of the blame for the crisis, but they continue to have strong political support. I would like to see both of them eventually dissolved, but that is unlikely to happen. Instead we are promised that they will be dealt with in future legislation, but I am skeptical that anything will be done to terminate either organization, or even improve their functioning.

 

5. Many proposals in the bill will have highly uncertain impacts on the economy. These include, among many other provisions, the requirement that originators of mortgages and other assets retain at least 5% of the assets they originate, that many derivatives go on organized exchanges (may be an improvement but far from certain), that hedge funds become more closely regulated, and that consumer be “protected” from their financial decisions. 

Most of these and other changes in the bill are not based on a serious analysis of what contributed to the financial crisis, but rather are the result of political and emotional reactions to the crisis. Usually, such reactions do more harm than good. That is likely to be the fate of the great majority of the provisions of the Dodd-Frank bill.

The Financial Regulation Law—Posner’s Comment

I agree with Becker’s criticisms of the new law (not quite a law yet—it has not been passed by the Senate, but I am guessing it will be, because an ignorant public demands action). It’s a monstrosity, and a gratuitous one, as there is no urgency about legislating financial regulatory reform. The financial regulatory agencies have ample, indeed essentially plenary, authority over the financial industry; and because they were asleep at the switch when disaster struck, they are now hyper-alert to prevent a repetition of it. Indeed, bank examiners have become so fearful of condoning risky banking practices that they are making it difficult for banks to lend to small businesses and consumers and thus are retarding the economic recovery.

 

The principal factors in the financial and larger economic collapse appear to have been : (1) Incompetent monetary policy under Alan Greenspan and his successor Ben Bernanke, which enabled the housing bubble. The bubble’s bursting brought down the financial industry, which was heavily invested in both residential and commercial real estate. (2) The inattention of the Federal Reserve and the Securities and Exchange Commission, which did not understand the changing nature of the banking industry, particularly the rise of “nonbank banks” dependent on short-term, uninsured capital. Solvency regulation of these banks was overly lax. (3) The overindebtedness of the American people and government, which has hampered the restoration of credit. And (4) the failure of the Treasury Department under Henry Paulson, and the Federal Reserve under Bernanke, to rescue Lehman Brothers; they didn’t realize that Lehman’s bankruptcy would trigger a run on the banking industry, causing a global credit freeze.

 

Obama’s principal economic officials—Bernanke, Timothy Geithner, and Lawrence Summers—were implicated in the regulatory oversights that precipitated the crisis, as were key legislative officials, such as Christopher Dodd and Barney Frank. None of them wants to shoulder blame for the crisis. They want to change the subject. So instead of blaming government, they blame the banking industry. The industry did take risks that were excessive from an overall social standpoint, but industry will always take the risks that government permits them to take, if the risk taking is highly profitable and losses if the risks materialize will fall mainly on others, which is what happened. Some banks took a hit, but the big ones are doing well. The government saved them from bankruptcy and has allowed them to borrow from the Federal Reserve at interest rates close to zero, thus enabling them to return to profitability without doing much lending, which banks are reluctant to do during a deep economic downturn, when default risk soars.

 

But for government officials to say "we blew it—we had the powers we needed to prevent the crash but failed to use them because we were complacent and inattentive" would not be a politically satisfactory response to the economic debacle. Just as politics requires that the President be seen to “do something” about the oil leak in the Gulf of Mexico, though there is nothing he can do, so politics requires that Congress “do something” to prevent a repetition of the economic disaster, though there is nothing it needs to do.

 

Much that the 2300 page long “Dodd-Frank Wall Street Reform and Consumer Protection Act” ordains is within the existing powers of the financial regulatory agencies to effectuate. For example, although the Act creates a Financial Stability Oversight Council (consisting mainly of the chairman of the Fed, the Secretary of the Treasury, and the chairmen of the Federal Deposit Insurance Corporation and the SEC) to advise the President and Congress on systemic risk, these officials don’t need legislation to hold regular meetings if that would be useful. The reason for creating such a Council is purely political: a governmental reorganization is a favorite response to a governmental failure because it is visible, easy to explain, usually cheap (it involves mainly just moving the boxes in a table of organization), and can be designed in such a way as to avoid ruffling too many interest-group and government-bureaucracy feathers. It also buys time, since no one expects a reorganization to be effective immediately.

 

In like vein the Act in several hundred pages directs the creation of a consumer protection bureau to be lodged in the Federal Reserve Board. The Fed already has such a bureau; it is ineffectual because the Fed cares about the solvency of banks, not the solvency of their customers. Congress proposes to correct this skew by making the head of the Fed’s consumer protection bureau (renamed the Consumer Financial Protection Bureau—renaming being the least arduous and hence an irresistible form of reorganization) a Presidential appointee—so he can squabble with the Fed’s chairman yet not be fired. The Federal Trade Commission, which is not protective of banks’ solvency, has extensive experience in protecting consumers, including consumers of financial products (the Commission enforces the Truth in Lending Act, for example), and could be given additional resources to police unfair and deceptive practices in mortgage and other consumer lending. While subprime lending contributed to the financial crisis, most subprime borrowers were not deceived, abused, intimidated, etc. Adjustable rate mortgages, strongly encouraged by Alan Greenspan, enabled people who could not afford the down payment on a house to buy a house anyway, gambling that continued housing price increases would give them an equity in the house that they could use to refinance with a conventional 30-year mortgage. If the gamble failed, they would go back to renting.

 

The new law increases the amount of equity capital that banks must hold, relative to their total capital, in order to reduce bankruptcy risk. But the Federal Reserve, in the case of commercial banks, and the SEC, in the case of nonbank banks (or the nonbank subsidiaries of commercial banks, such as Merrill Lynch, now a part of Bank of America), already have the authority to decide how much equity capital, relative to debt, the firms they regulate must hold.

 

The legislation requires that most credit-default swaps (a form of credit insurance, but also a device for speculating on bond prices and defaults) be traded through clearinghouses and on public exchanges, as publicly traded stocks are. Uncertainty about the liabilities and solvency of issuers of credit-default swaps did contribute to the financial panic of 2008, but can be dispelled by requiring fuller public disclosure of firms’ off-balance-sheet contingent liabilities, including not only credit-default swaps but also the “structured investment vehicles” in which banks parked their mortgage-backed securities. Requiring such disclosure is again within the existing authority of the financial regulatory agencies.

 

It may be argued in defense of the new law’s apparent redundancy that the agencies didn’t use their authority to avert the crisis (which is true), so they must be ordered to use it to avert future crises--which doesn’t follow. It is a mistake for Congress to instruct regulatory agencies on the details of how to regulate. The idea behind administrative regulation is that agencies hire experts to deal with technical issues that Congress has neither the competence nor the time to resolve. Legislation once adopted is difficult to change, and can squeeze a regulatory agency into a straitjacket. This is a particularly serious concern in the case of finance, an industry that experiences continuous change.

 

Besides trying to micromanage the regulatory process in some respects, the new law in other provisions takes a different tack and directs the regulatory agencies merely to study particular problems. This is a waste of ink. All the senior financial regulators are appointees of the Obama Administration. If there are areas of financial regulation that would benefit from further study—and there are—the White House can tell its appointees to do so. There is no need for a congressional prod.

 

There are little nuggets here and there, such as the abolition of the faitnéant Office of Thrift Supervision, but on the whole, so far as I can judge, the new law is a political measure in the worst sense.

The Gulf Oil Leak—Posner

British Petroleum’s drilling accident in the Gulf of Mexico this past April is the latest of several recent disastrous events for which the country, or the world, was unprepared. Setting aside terrorist attacks, where the element of surprise is part of the plan, that still leaves the Indian Ocean tsunami of 2004, Hurricane Katrina in 2005, the global economic crisis that began in 2008 (and has been aggravated by Greece's recent financial collapse), and the earthquake in Haiti last year.

The reaction to the latest accident has been surprising. Oil spills and underwater drilling accidents are common, and despite the media hype it is too soon to tell whether this one will prove to be the biggest yet. The amount of oil leaked so far is substantially less than the amount spilled or leaked in previous accidents, including at least one in the Gulf of Mexico.

It is also surprising that so much criticism has been directed at the Obama Administration, and indeed against Obama personally. Most of the criticism is absurd—his failure to react emotionally, and his inability to “just plug the hole,” are not personal or professional failings. The Minerals Management Service in the Department of Interior does seem to have been asleep at the switch, but Obama unlike his immediate predecessor cannot be criticized as being hostile to regulation—if anything, he has too much faith in it. MMS is a small and obscure agency far below the horizon of a president’s supervision. No president can eliminate all pockets of incompetence in the vast federal government.

It is possible that the number of recent disasters has created a public sense that something is wrong with government: that it ought to be able to prevent all disasters. But this is an unrealistic expectation. Everything conspires against a government’s being able to protect its people against disasters, whether natural or man-made. A factor that retards prevention of man-made disasters is the rapid and relentless advance of technology. Regulation lags innovation. The Federal Reserve, Treasury Department, and SEC were no more able to keep abreast of advances in financial engineering than MMS was to keep abreast of advances in drilling for oil at very great depths under water. Slack regulation encourages private companies to adopt a high-risk business model. Risk and return tend to be positively correlated, in finance because risky loans command higher interest rates and in underwater drilling because risk abatement is costly. Business is particularly reluctant to take preventive measures against unlikely disasters because they do not pose a serious near-term threat. If there is a 1 percent annual probability of a disastrous drilling accident or financial collapse, the probability that the disaster will occur any time in the next 10 years is only 10 percent. Business managers have finite planning horizons just like politicians.

Of course, if the consequences of a disaster would be very grave, the fact that the risk is low is not a good reason to ignore it. But there is a natural tendency to postpone taking costly preventive action against dangers that are only likely to occur at some uncertain point in the future (“sufficient unto the day is the evil thereof,” as the Bible says), especially if prevention is expensive, if the probability and often the consequences of disaster cannot be estimated with any confidence, if remediation after the fact seems like a feasible alternative to preventing disaster in the first place—and because there is so much else to do in the here and now than worry about remote eventualities. The overcautious business will lose profits, investors, and staff to its bolder competitors; the overcautious regulator will be harassed by politicians pressured by business, labor, and other interest groups.

All the factors that I’ve identified came together to enable the economic crisis, despite abundant warnings from reputable sources, including economists and financial journalists. Risky financial practices were highly profitable, and giving them up would have been costly to financial firms and their executives and shareholders. The Federal Reserve and most academic economists believed incorrectly that in the event of a crash, remedial measures—such as cutting interest rates—would suffice to jump-start the economy. Meanwhile, depending on how they were compensated, many financial executives had a limited horizon; they were not worried about a collapse years down the road because they expected to be securely wealthy by then. Similarly, elected officials have short time horizons for policy; with the risk of a financial collapse believed to be low, and therefore a meltdown unlikely in the immediate future, they had little incentive to push for costly preventive measures, and this in turn discouraged the appointed officials of the Federal Reserve and other regulatory agencies from taking such measures. Finally, with no reliable probability estimate of a financial collapse available, it seemed prudent to wait and see, hoping that with the passage of time at least some of the uncertainty about risks to the economy would dissipate.

The BP oil leak reveals a similar pattern, though not an identical one. One difference is that the companies involved must have known that in the event of an accident on a deepwater rig prompt and effective remedies for an oil leak would be unlikely—meaning that there was no reliable alternative to preventing an accident. But the risk of such an accident could not be quantified, and it was believed to be low because there hadn't been many serious accidents involved in deepwater drilling. (No one knew how low; the claim by BP chief executive Tony Hayward that the chance of such an accident was "one in a million" was simply a shorthand way of saying that the company assumed the risk was very small.)

But other causal factors were similar in the leak and the financial crisis. If deepwater oil drilling had been forbidden or greatly curtailed, the sacrifice of corporate profits and of consumer welfare (which is dependent on low gasoline prices) would have been great. Elected representatives did not want to shut down deepwater drilling over an uncertain risk of a disastrous spill, and this reluctance doubtless influenced the response (or lack of it) of the civil servants who do the regulating.

The horizon of the private actors was foreshortened as well. Stockholders often don't worry about the risks taken by the firms in which they invest, because by holding a diversified portfolio of stocks and other financial assets an investor can largely insulate himself from risks taken by any particular firm. Managers worry more about the fate of their company because they often are heavily invested in it terms both of human capital and of reputation. But they rarely are held personally liable for the debts of the firms they oversee and, more important, the danger to their own livelihood posed by seemingly small risks is not enough to discourage risk-taking.

Two final problems illuminate the nation’s vulnerability to disasters. First, it is very hard for anyone to get credit for preventing a low-probability disaster. Because such a disaster was unlikely to occur, the benefits of taking action beforehand could not be assessed unless the preventive action took the form of a dramatic last-minute save. Had the Federal Reserve raised interest rates in the early 2000s rather than lowering them, it might have averted the financial collapse in 2008 and the ensuing global economic crisis. But we wouldn't have known that. All that people would have seen was a recession brought on by high interest rates. Officials bear the political costs of preventive measures but do not usually reap the rewards.

The second problem is that there are so many risks of disaster that they can't all be addressed without bankrupting the world many times over. In fact, they can’t even be anticipated. In my 2004 book Catastrophe: Risk and Response, I discussed a number of disaster possibilities. Yet I did not consider volcanic eruptions, earthquakes, or financial bubbles, simply because none of those seemed likely to precipitate catastrophes.

It would be nice to be able to draw up a complete list of disaster possibilities, rank them by expected cost, decide how much we want to spend on preventing each one, and proceed down the list until the total cost of prevention equals the total expected cost averted. But that isn't feasible. Many of the probabilities are unknown. The consequences are unknown. The costs of prevention and remediation are unknown. And anyway, governments won't focus on remote possibilities, however ominous in expected-cost terms. A politician who proposed a campaign of preventing asteroid collisions with Earth, for example, would be ridiculed and probably voted out of office.

 

The Gulf Oil Leak and Optimal Safety Precautions-Becker

Economists over the years have had a schizophrenic attitude toward low probability but highly costly events. One school of thought argues that most people give less attention to such events than is merited, and that this explains why many households do not to take out flood, earthquake, and other insurance on very small risks (although there may be other explanations of this fact). Some psychologists and economics claim the opposite, that people give too much attention to low probability events, as in much of modern behavioral economics.

Whether BP paid enough attention to the chances of and damages from a serious leak on its Deepwater Horizon rig in the Gulf of Mexico is at the heart of any evaluation of whether BP was negligent in its safety approaches to this well. The chief executive of BP, Tony Hayward, claimed that an accident of the magnitude of this one had “a one in a million” chance. It is ironic that when Hayward became chief executive, he vowed to focus “like a laser” on safety and reliable operations.

Suppose that his estimate is correct, in the sense that the probability of an accident of this magnitude in any year was one in a million. If the accident ends up causing a $100 billion worth of damages to fish, beaches, loss of lives, and in other ways, the discounted value (at a 5% interest rate) of this expected cost over time would then be approximately 20 times $100 billion divided by one million, or $2 million. A risk neutral BP would rationally not want to spend more than that amount to prevent such a leak from happening. Perhaps the damages from this oil spill will turn out to be as much as $200 billion, although this seems highly unlikely, especially since the value of BP’s shares have declined by about $90 billion since the April 20^th disaster. Even if the damages were more than twice as large as the decline in share value, the expected damages would only be about $4 million, a modest expected risk for any large business.

Of course, to justify their poor preparation to combat such a large leak of oil, Hayward may have greatly understated its probability. As Posner emphasizes, it is very difficult to estimate with any precision what is the actual probability of highly infrequent events, and such a leak would fall within this class. So if the annual probability were really more like 1/10,000 rather than 1/1,000,000, the expected discounted cost would be about $200 million, a more considerable sum. These examples show that only when the annual probability of such a disaster was reasonably large would it have paid for BP to spend a lot to prevent such a leak from happening.

Given the litigation that resulted from the 1989 Exxon Valdez oil spill off Alaska, and from other oil leaks, BP should have expected that it would be held liable in court for the damages caused by leaks from its deep water drilling. However, it could hardly have expected to be liable for new types of claims, such as the one proposed by the Obama administration that BP should be responsible for the wages lost by workers who are laid off as a result of the six month moratorium proclaimed by the president on all drilling off the American coast. It is ironic that Obama had on March 31^st, just a few weeks before the Deepwater Horizon oil spill in April, proposed an extension of offshore drilling. Nevertheless, if the Deepwater leak alerted us to greater risks of offshore drilling than had been realized, BP should not be punished for (inadvertently) providing this useful information.

The president may be right in asking for a moratorium to spend a few months reviewing the safety precautions on all drilling off the US coastline. However, it would be unfortunate if this disaster led to permanently much greater restrictions by the US on offshore drilling for oil since that is at present the most promising source of additional US production of oil. The likelihood, and cost, of future spills has to be weighed against the gains to US national security and energy independence from having greater access to domestically produced oil. Since I believe these gains are substantial, I expect offshore oil production to continue to have an important place in US (and other countries) production of oil since offshore oil is the last frontier in the search for new deposits of oil.